Shifting IRA funds can pay college costs

Q: I am using my IRA as a savings plan for my children's college expenses. According to the IRS Web site, I can use the funds in my IRA to pay for my children's college expenses without penalty.

I know I will have to pay taxes on the earnings when I make withdrawals, but that's OK, because the money has been growing tax-deferred all these years. I never saw the point in opening a 529 college savings plan, because I knew I could save enough in my IRA to pay for my retirement and my children's college costs, killing two birds with one stone.

My IRA is in a mutual fund, and I want to know if it is possible for me to:

1) transfer shares of the fund into a new account in each of my sons' names without selling the fund shares, and therefore not pay tax on the capital gains.

2) have my sons sell the shares themselves and avoid taxes on the proceeds, provided the proceeds are less than $12,000.

I wonder how many parents use their IRAs to pay their children's college expenses. Is this common?

A: It is obvious from your question that you know a little bit about many different financial subjects.

Your question covered the exception to early-withdrawal IRA penalties for education expenses, transferring of mutual fund shares for gifting, 529 plans, and potentially lower capital-gains rates for minors.

I don't blame you for trying to tie all of these together to work in your favor, but Congress isn't quite as naive or helpful as you would like to believe.

Maximizing retirement savings before beginning an education savings plan is always a good idea.

Ask young adults whether they would rather graduate with debt or have their college expenses covered by their parents -- if that would require their retired parents living with them in the future. The majority would opt for the debt.

As you have done, once adequate retirement funding is accomplished, excess money can be tapped for education. If one's retirement savings will be adequate and additional money can be saved for college education, directing this to a plan such as a 529 college savings plan is recommended.

The 529 plan is funded with after-tax dollars, but all growth is tax-free when used for approved education expenses. With the exception of the Roth IRA and after-tax contributions, withdrawals from retirement funds used for qualifying education expenses will be subject to ordinary income tax.

You can only transfer shares in-like-kind from your IRA to another IRA that you own. Money withdrawn from an IRA (other than after-tax contributions) will be subject to ordinary income tax; there is no capital gains tax treatment.

If you want to give a gift to your children from your IRA, you will need to sell shares in your IRA, pay tax on the withdrawal and give the money as a gift to your sons. An annual gift of $12,000 or less to any individual will not require filing a gift-tax return. A gift of any amount paid directly to an educational institution to cover qualified education expenses will not require the filing of a gift-tax return.

Even if your mutual fund shares were in a taxable account, Congress took away the tax advantage of gifting appreciated shares to full-time students 23 and under. Before the new "kiddie tax" law, unearned income (total income, minus earned income, minus unearned or investment income) of children under 14 was taxed at the parent's rate, but unearned income of children 14 or over was taxed at the typically lower children's tax rate.

Unearned income of more than $1,800 of a full-time student under 24 will be taxed at the parent's rate. Investment income will first be reduced by a $900 standard deduction; the next $900 will be taxed at the child's rate, and the remainder at the parent's rate.